Obtaining the necessary funding for your small business expansion may seem unattainable. Every day, you must make dozens of decisions about hiring new staff, selecting the best software, and locating clients interested in your offering.
Many small business owners choose to stick with what they know and obtain funding through a traditional bank loan because they have a lot of decisions to make. Although it’s one of the most popular methods, other options exist for raising money.
In this post, we’ll review how venture debt works, including its benefits and drawbacks, so you can decide if it’s the best option for your company.
What is Venture Debt?
A type of debt financing provided to startups and companies backed by venture capital in their early stages is called venture debt. Thanks to it, these businesses can benefit from liquidity between equity funding rounds. Venture debt is not the same as a long-term source of funding.
Venture debt loans are typically returned in 18 months, but they can take up to 3 years to pay back. This is because venture capital lenders anticipate repayment through the funds that businesses receive in their upcoming funding rounds.
How does venture debt work?
Non-bank lenders or banks specializing in venture financing offer venture debt. Other well-liked choices for venture loan providers include hedge funds, business development organizations, and private equity firms.
The amount raised in the previous equity financing round is used to calculate the principal amount of debt.
Because of the high default risk associated with venture debt, lenders can purchase company stock at a predetermined price within a predetermined time frame. This financial security is commonly referred to as warrants. The warrants can be issued for one to fifteen years, and their total value can range from five to twenty percent of the loan’s principal. The lender can purchase stock, but they are not required to.
Covenants also apply to venture debt loans. These additional terms and restrictions are in place to ensure that the borrower pays back the loan. Lenders may impose both financial and non-financial covenants.
Since every company is different, terms will vary among startups. On the other hand, most companies can anticipate seeing the following terms on their term sheet for venture debt:
- Rate of interest: Variable rate of interest determined by the prime rate.
- Loan size: The total amount the venture term loan provides your company.
- Duration of repayment: a predetermined amount of time to pay back the principal and interest on your loan.
- Collateral: Any property, such as business assets, that you agree to return to the lender if you cannot repay the loan.
- Agreements: Conditions that your lender enforces and that, if broken, could result in you defaulting on your loan.
- Depreciation: Your loan payback schedule.
- Warrants: Legal right to buy stock in your company for a set price for a predetermined amount of time.
Types of Venture Debt
The three primary forms of venture debt types are as follows:
- Receivables: The borrowers’ financial statements are the basis for this venture debt. Businesses can borrow money based on the accounts receivable listed on their balance sheet.
- Term loans: Term debt, commonly referred to as term loans, comes with a three-year repayment period. High-growth businesses receive these loans and must repay a portion of the funds each month. Term loans typically represent senior debt. This implies that if a business doesn’t make payments, they are paid back in full through an exit or bankruptcy.
- Monetization of royalties: A more adaptable type of venture financing is royalty monetization, which is based on the borrower’s projected revenue stream. Your loan repayments fluctuate in tandem with your company’s revenue performance.
Advantages and disadvantages of venture debt
Small business financing is never an easy undertaking. There are several benefits to venture debt financing, but there are drawbacks as well. The following are some benefits and drawbacks of venture debt:
Venture Debt Pros
Venture debt is a great strategic tool that empowers startups in extending their runway or gaining a competitive edge in the market. Some of the key advantages include:
- Cutting down on equity dilution: Reducing your company’s equity dilution is one of the main benefits of venture debt. You can obtain more funding as a business owner without giving up much of your ownership. Even if you forfeit some common or preferred stock in your company, the amount will be far less than what you would forfeit in the event of a full equity round of funding.
- Access to a flexible funding source: Venture debt can keep your startup afloat in case of unforeseen market conditions or short-term obstacles.
- Growth-boosting: By extending your company’s cash runway, venture debt helps your business grow. It can increase the time between funding rounds and give you more time to reach deadlines.
Venture Debt Cons
Venture debt comes with numerous advantages, but it does present certain challenges. Startups should be mindful of the potential drawbacks:
- Adversely impact upcoming funding rounds: A venture debt loan agreement may make it more difficult for your company to get additional funding in the future. Debt on your company’s balance sheet could raise concerns from potential investors. They may be reluctant to provide much-needed funding because their investment will pay off your debt.
- Repayment terms could be challenging to fulfill: You must repay your venture debt in accordance with its terms, including interest. A young company with erratic cash flow may struggle to meet its monthly obligations.
- Failure of financial covenants: Financial covenants are typically associated with venture debt. These prerequisites must be met to keep the venture debt lender’s capital available. Serious consequences may result from not adhering to these requirements. To recover their money, the lender may impose higher interest rates on any outstanding debts owed by your company, demand full repayment, or even file for bankruptcy.
When does venture debt financing become a practical choice?
If any of the following apply to your business, venture debt financing might be a good fit:
- You are nearing profitability: Businesses close to profitability might require an additional push to go public without further equity dilution.
- Finance in between equity rounds: Rather than choosing to raise a bridge round from their current venture capital firms, many companies choose to use venture debt. For example, you raised $21 million in your series. A funding round and now need to raise an additional $26 million to reach your next business milestone. You can obtain this growth capital using venture debt without going through a VC bridge round.
- As an insurance policy: If your company requires additional time to reach its next milestone, keep some extra cash as a safety net. Venture lending gives you access to capital to sustain your company until this occurs.
When should businesses avoid venture debt lending?
Even though venture debt financing is a fantastic choice for some startups, there are some circumstances in which it’s preferable to select an alternative method of financing.
- Your business is not doing well: Steer clear of venture debt financing if your startup has financial difficulties, and there is little chance you will be able to raise additional equity. Businesses should only take out venture debt if they have investors who will contribute additional equity soon, enabling them to repay the loan.
- Investors from venture capitalists oppose it: While having venture debt may not automatically disqualify you from investors, it could cause them to pass on your business if they believe the VCs will be challenging to work with.
- You must return the loan immediately: A loan with an immediate repayment requirement may ruin your chances of using the money at all. A loan with an instant amortization could compel your business to pay back a significant amount of the loan before you can use the funds for significant business achievements.
Is venture debt the right choice for your startup?
High-growth startups frequently struggle to get the funding they require to expand if they don’t have years of financial data to support their claims. Traditional commercial bank underwriting procedures usually demand approval for a sizable minimum bank balance. Companies with modest budgets or those in the eCommerce sector operating on slim margins might find that other funding options are insufficient.